The Great Recession, Stimulus Bill, and the US economy

Brad Plumer points to these two excellent graphics (from the Economic Report of the US President) that maps the impact of fourteen cases of banking/financial crises induced economic recessions from across the world.

1. The average increase in unemployment rate from the peak of the business cycle is 7.7 percentage points for the 14 cases, whereas in the Great Recession during 2007-09, the US economy suffered a 5.1 percentage points rise unemployment rate.



2. The average cumulative decline in real GDP from the business cycle peak for the 14 cases has been 10.2 percentage points and the average duration of recessions has been 6.6 quarters, measured as the number of quarters between the peak and trough of real output. In the Great Recession, the US economy suffered a 5.1 percentage points cumulative drop in real output and it has taken 6 quarters to regain the lost output.



There have been many studies which have examined the impact of the American Recovery and Reinvestment Act 2009 in shortening the recession and keeping unemployment rates from getting higher. This summary of nine economic studies on the stimulus bill reveals that six found a significant positive effect on growth and unemployment, while three found either a small or hard-to-predict effect. The US President's Council of Economic Advisers' most recent assessment of the ARRA found that, as of mid-2011, there would’ve been between 2.2 million and 4.2 million fewer Americans employed if the bill had never passed.

The graphics below, from the CEA report, highlight the impact of ARRA on the post-ARRA GDP and employment creation.




But the recession has surely taken a toll on the US economy. The graphic below shows that the Bush era tax cuts and lost revenues from the economic downturn are the major contributors to America's massive fiscal deficit.

Debt restructuring or default - Is it enough?

Call it whatever you like, Greece has effectively defaulted on its sovereign debt, atleast half of its private external debt. The agreement that private investors will take a 50% haircut on their bonds constitutes a virtual default. The agreement reached to resolve Eurozone crisis contains this restructuring of Greek debt, a bank recapitalization plan, and an expansion of Eurozone bailout fund.

The agreement to restructure Greek debt also includes a new €130 bn bail-out of Greece by the European Union and the International Monetary Fund and is estimated to reduce Greek debt levels to 120% of GDP by end of the decade. The deal includes a decision to force the continental banks to raise new capital amounting to a total of €106 bn ($150 bn) by June 2012 to raise their Tier I capital ratio to 9% of total capital so as to provide them with greater cushion against potential losses on loans to the PIIGS.

They also agreed to increase the firepower of the remaining amount in the €440 bn ($610 bn) European Financial Stability Fund (EFSF) (estimated to be about €250bn after the proposed new Greece debt deal) by providing "risk insurance" to new bonds issued by struggling eurozone countries, especially Italy. This would limit bondholder losses by guaranteeing a portion of potential losses - EFSF effectively offers credit protection on Greek debt. It is hoped that this would increase the size of the EFSF by 4-5 times to about €1,000bn. Efforts are also on to get outside investors like sovereign welath funds from China, Russia and others.

Though any agreement is welcome, there are several doubts about whether this is a case of too little too late. Critically, even after the haircuts and bailout, Greece will still have a debt-to-GDP ratio of 120% even in 2020. This raises questions about its effectiveness and increases the possibility of more write-downs and bailouts. This would mean complete wiping out of private bondholders and even write-downs by official lenders (who will be the last to suffer any haircuts). Of the 340 billion euros in Greek government debt, only about 200 billion euros is owed to private creditors and therefore covered by the restructuring plan. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring. FT Alphaville has several interesting questions here about the details of the three-pronged bailout plan.

In addition there are more fundamental issues. Eurozone countries' economic stagnation which is driven by a combination of declining economic competitiveness, huge sovereign debts, and difficulty in financing government deficits. The beleaguered peripheral Eurozone economies are handicapped by the unavailability of all the remedies traditionally used by countries facing recession and sovereign debt crisis - inability to indulge in fiscal and monetary expansion, reflate their economies, or devalue their currencies. Though notionally a currency union with a harmonized monetary policy, it does not have any central fiscal authority nor does it have a monetary authority willing to assume its traditional role. In simple terms, Eurozone is a monetary union without a fiscal federation or a full-fledged central bank.

The better placed economies like Germany are strongly opposed to fiscal transfers to bail out their reckless peripheral partners. The European Central Bank (ECB) has refused to lend to its struggling member states. It has preferred to let the newly created and limited European Financial Stability Fund (EFSF) assume the responsibility of lending to those countries and stabilizing the financial markets.

This is in sharp contrast to the policy followed by the US Treasury and the Federal Reserve when faced with similar (some would say, less severe) crisis in late 2008. The Government announced a massive stimulus package to stabilize the economy, while the Fed deployed extraordinary measures to emerge as the lender, buyer and insurer of last resort.

In fact, unlike the US and British bank recapitalization plans in which the respective central banks injected funds directly, the ECB has refused to do so. The banks are therefore relying on private investors to raise their capital so as to reach the 9% level. However, raising money from private investors will be difficult especially given the conditions.

The current conditions call out for proactive central bank leadership. No one seriously disputes that Spain and Italy, currently the biggest concerns, are solvent and are only experiencing a liquidity crisis. Such crises are best averted when central banks step in and open liquidity windows and function as lender of last resort. As Martin Wolf wrote recently, if sovereign default risk is addressed, it will "also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency". See also this excellent paper by Paul De Grauwe. In light of all this, it remains to be seen whether the latest bailout will be effective.

Times, as always, has this nice graphic that captures the three prongs of the bailout plan.



The market reaction has be positive, with Greek CDS spreads nearly halving from 6000 to 3500.

Does Europe needs its version of TARP/TALF?

It is increasingly evident that the Eurozone stands at the precipice, with the serious danger of carrying the world economy down with itself.

The combined ECB-IMF bailout, operated through the European Financial Stability Fund (EFSF) appears too little to make any meaningful dent on Europe's growing list of problems. In simple terms, Europe is facing its Lehman moment. The markets are clearly unimpressed by the amounts provided under the EFSF and are ratcheting up the pressure on the peripheral economies. In recent weeks, the cost of insuring Greek and Italian debts have exploded, as have their bond yields and spreads with German bund. Europe clearly needs much more ammunition in its armoury to come out of this with the Eurozone intact and without suffering massive economic damage.

The obvious risk is the catastrophic cascading effect a sovereign default can have on the global financial markets, leave alone the European markets. More immediate danger, and one which is already playing itself out, is the credit squeeze being felt by most European financial institutions, as wary lenders from across the Atlantic and elsewhere are working out ways to pare down their Eurozone exposure.

A sovereign default by Greece, while theoretically manageable, is certain to amplify market uncertainty and risks across the financial markets, and thereby increase the pressure on countries like Italy. A run on Italy, leave alone a full-fledged default, will be well-neigh unmanageable. The European financial markets are most certain to seize as these dangers start showing up in the aftermath of a Hellenic default. And the impact of all these on the global financial institutions, on both sides of the Atlantic, including Germany, will be very damaging for their balance sheets.



The need of the hour then, as US faced in the aftermath of the Lehman default, is to immediately address the solvency and liquidity crisis that is brewing and threatening to go out of hand. The former requires a massive banking recapitalization program, while the later demands opening an expansive liquidity injection window. The Euro 440 bn EFSF, intended to inject capital into distressed banks and purchase sovereign bonds so as ease the pressure on their yields, may be too little too late to serve the purpose.

The EFSF will be able to lend up to 440 billion euros, or about $600 billion, and issue guarantees for 780 billion euros. However, a more realistic requirement is estimated at nearly 2 trillion Euros. Given the politics of Eurozone, this looks clearly unrealistic. Though announced more than three months back, the EFSF is yet to get approval in all member Parliaments, highlighting the difficulties of decision making in the Eurozone area. Even otherwise, with a total Eurozone GDP of 9.5 trillion euros, this would be more than 25% of the total GDP.

In the US in 2008, as part of the TARP and the TALF, the Treasury and the Fed carried out both operations, with the former in massive scale. Liquidity windows were opened, blanket credit guarantees provided, collateral standard relaxed, and the Fed even carried out massive purchases of certain failing assets in order to backstop the markets. The Fed almost tripled its balance sheet to emerge as an effective lender, insurer and even buyer of last resort to prevent the markets from fully seizing up.

Such aggressive actions may be required to soothen the markets somewhat and weaken the grip of widespread panic. If the liquidity infusions are in sufficient size and done without much delay, it may be possible to buy enough time for the beleaguered institutions to recover some lost ground, and bring some semblance of normalcy back to the markets, thereby preventing a full meltdown. One of the big policy successes, atleast in terms of its immediate objective, of the past four years has been the US financial market bailout initiated in late 2008. Addressing the deeper and fundamental issues of individual bank solvency and economic and financial market restructuring can be taken up once this stage is surmounted.

But there are serious doubts about the effectiveness of such policies in stemming the panic. The assumption is that equity injections and credit infusions will buy enough time for the Eurozone economies to restore market confidence, lower the cost of financing their sovereign debt, bring debt servicing burden under control, and put the economy back in a robust growth path. But critics have raised doubts about this optimism.

The biggest structural problem facing many of these economies, especially Greece, Portugal, and Italy, is the need to reduce their cost of production and regain competitiveness. This is traditionally done by devaluing domestic currency or cutting wages. The former is not an option as long as they remain within Eurozone, while the later will in all probability exacerbate the problem and push the economy further down. This could in turn trigger off a debt spiral, further increasing the debt-to-GDP ratio and sovereign debt servicing costs.

In any case, given all the aforementioned, if the Euro experiments has to survive, it is inevitable that the core economies step in with more explicit and larger support for the beleaguered peripheral ones. That support has to come either in the form of direct fiscal transfers or some mixture of monetary expansion, including some way using the Eurozone's combined balance sheet to finance the debt of the weakened economies, and partial defaults or haircuts. Preferably all of them. Further, the more this intervention is delayed, the steeper will be the recovery path and higher will be the price to be paid.http://www.blogger.com/img/blank.gif

Update 1 (6/10/2011)

The ECB and Bank of England announced measures to support the financial markets. ECB said it would start offering banks unlimited loans (banks have to put up collateral like bonds or other securities) at the benchmark interest rate for about one year, up from the previous six months. The ECB also said it would resume buying so-called covered bonds, which are a form of debt secured by packages of loans and guaranteed by the issuing bank. Covered bonds are one of the main ways that banks raise money.

The Bank of England decided to retain interest rates at 0.5% and also announced the decision to widen its so-called quantitative easing program to £275 billion, or $425 billion, from £200 billion.

Update 2 (13/10/2011)

On what needs to be done for Europe, Martin Wolf writes,

"The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011."

But he identifies the formidable challenge of making crisis management compatible with fiscal adjustment,

"... there is an opposing risk, that forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.

No doubt, a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure."

Obama's Jobs Plan in graphics

(HT: Washington Post)

The "long" fiscal stimulus - a belated recognition of infrastructure spending?

Prof Tyler Cowen has a strange post. He points to the inadequacy of short-term stimulus spending, however large, to tide over deleveraging balance sheet recessions. He is therefore surprised that

"For all the talk of a 'large stimulus', you don’t hear much about a 'longer stimulus'."

He has this concern about short-term pump priming, whatever its size,

"The problem with a 'too small' stimulus is that you get an initial economic boost, but when the stimulus expires the economy slumps back down, as indeed happened in mid 2011. Ideally a stimulus employs some idle labor, stops it from depreciating, and tides those workers over until they can look for other jobs in fundamentally better economic conditions... If conditions are not improving soon, the ability of the stimulus to 'buy time' for those workers isn’t worth much... We end up having spent a lot of money to postpone our adjustment problems, rather than achieving takeoff. Deleveraging recessions last a long time, as shown by Rogoff and Reinhart. The need for continuing deleveraging implies that even a stimulus twice the size of ARRA won’t turn the tide."

In the circumstances, his suggestion,

"In those cases a well-designed stimulus program should not be so 'timely'. For a given presented expected value sum spent on stimulus, it is better to spread it out across the years. It is better to help a smaller set of workers for five years (or however many years it takes for most of the deleveraging to end), after which they are reemployable, than to temporarily boost a larger number of workers for two years, and then leave them back in the dust because deleveraging is still going on."

Here we go! There appears to be, to put it very charitably, an element of selective amnesia in Tyler's post here. This is effectively an admission of ideological failure (or, is it an error of judgement?) and an advocacy for focusing stimulus spending on creating durable public infrastructure assets atleast now.



In some sense, it is a classic case of the two-handed economist at work, albeit with a time lag in the action of the two hands. The one hand which had considered, debated and opposed the same when the ARRA was being formulated now appears to have changed track and embraced infrastructure spending when the earlier assumptions were proved wrong.



As early as late 2008, when the ARRA was being conceptualized, there was an intense and often acrimonious debate about the nature of the stimulus. Conservatives, who even then opposed any fiscal action, were willing to go only as far as tax cuts. They had opposed it on the grounds that there was no shelf of "shovel ready" infrastructure projects and that such spending takes time before its shows any stimulus effect on the economy. Marginal Revolution itself had directly posted and linked to several such views. In contrast, liberal economists like Paul Krugman, Mark Thoma and Brad DeLong felt that the recession was likely to persist for long and therefore preferred direct spending in infrastructure assets.



From hindsight, even the most conservative of economists would admit that the best course of fiscal policy action in late 2008 would have been to spend money on public infrastructure creation. The ultra-low interest rates, now certain to persist well into 2013 and atleast for a couple of years beyond that, would have provided unbelievably cheap financing for atleast 7-8 years. If in 2006, Congressmen and academics had been offered the prospect of accessing interest free loan for 8-10 years to repair America's battered infrastructure, many of them would have readily grabbed that opportunity. In fact, even the China-bashing Americans would have derived some vicarious pleasure from the realization that China was subsidizing America's infrastructure creation by offering virtually interest free loans!



In fact, Tyler's invocation of Reinhart-Rogoff now to fortify his argument about the pernicious nature of deleveraging recessions, appears to be a case of "what is sauce for the goose (is not) sauce for the gander"! Interestingly, Messers Krugman and Co had then invoked precisely the same duo to base their claim for infrastructure spending based stimulus. They had argued, based on the substantial body of empirical evidence presented by Reinhart-Rogoff about the average lengths of banking crisis induced recessions, that the Great Recession was likely to be a long drawn out one and therefore there was enough time for infrastructure spending to be effective.



The ideal course of action in late 2008 would have been to adopt a two-pronged approach, one which many of the aforementioned liberal/Keynesian economists did advocate, involving long-term stimulus on infrastructure creation and automatic stabilizers like unemployment insurance and food stamps to cushion the worst hit by the recession. Any tax cuts and other stimulus spending would have been an additional bonus.



I am inclined to believe that the impact of such spending on the economy as a whole would have been positive in many dimensions. Apart from the fact that it would have repaired or replaced the country's battered infrastructure, it would also have generated a significant multiplier on the economy on many fronts. It would have brought to work idle resources, encouraged businesses to not postpone investments, spurred market confidence (yes, the "confidence fairy"!) in the long-term health of the country, and so on. Given the fact that these investments were in any case necessary, one would also have to add the opportunity cost benefits of the ultra-low interest rates to calculate the multiplier.



In view of all the aforementioned, the final paragraph to Tyler's post is a sad commentary of the dark age of macroeconomics,

"Oddly, there is not much discussion about the length of fiscal stimulus. But there should be."

PS: I just did not have to energy to mine the numerous links in MR, and Krugman, Thoma and DeLong's blogs that contain the specific material from 2008-09 that I have alluded to in the post. I guess I am lazy! Anyways, interested readers could do so from here and here.

The counterfactual problem in public policy

Heads I win, tails you lose! This aphorism could well describe the debate on many intractable public policy issues, those where conclusive answers are difficult to come by. Supporters claim that it would have been worse without the intervention. Critics denounce the intervention as a failure since the problem persists. The challenge with all such issues is the difficulty of establishing the counterfactual. Let me illustrate this dilemma with three examples.

The most famous counterfactual problem of our times is the debate on the impact of expansionary policies implemented in the US in the aftermath of the Great Recession. Conservatives point to the persistent high unemployment rates and weak economic conditions, despite the extraordinary fiscal (more than $ 1 trillion) and monetary expansion (zero bound rates and $2.3 trillion QE), as conclusive proof of the failure of expansionary policies.

They reinforce their argument by pointing to the failure of the now infamous recovery projection, estimating future unemployment rates with and without a stimulus plan, made in January 2009 by Christina Romer and Jared Bernstein, then part of President Barack Obama's team. Their way-off-the-mark estimates suggested that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan.



In May 2011, using the latest figures available from the BLS, the unemployment rate reached 9.1%. In contrast to the Romer and Bernstein projections which estimated that the unemployment rate would be around 8.1% for May without a recovery plan, or 6.8% with a stimulus plan, the actual rate was 9.1%. The actual unemployment rate has been consistently above Romer and Bernstein’s worse case scenario for the economy – and by a considerable margin. Critics of the stimulus invoke this as proof of its complete failure. After all, though a massive and unprecedented monetary and stimulus was enacted, it appears to have had no impact in terms of improving the economic conditions.

Supporters of the stimulus in turn point to other statistics to put forward their claims about how the stimulus created employment, supported the poorest, propped up aggregate demand, and helped local governments. They argue that in the absence of the stimulus measures, the counterfactual, the economy would have plunged into a full-blown depression.

Further, economists like Paul Krugman have consistently held that the actually enacted stimulus policies have been severely deficient and have been advocating much larger doses of expansion to mitigate the high unemployment rate. In the absence of the required magnitude of expansion, they claim, it is unfair and incorrect to blame the expansionary policies for the economy languishing.

Such counterfactual problems are pervasive in economic policy making. This is especially so given the impossibility of localizing and quantifying the impact of specific policy interventions. In the circumstances, if the intervention fails to yield the desired result, critics will denounce it as a failure. Supporters will find that establishing the counterfactual, the scenario in the absence of the stimulus, is fraught with insurmountable difficulties.

Another example of such analysis is the debate about the benefits of metro-rail in New Delhi. Critics argue that despite the massive investments in the Metro, the Delhi traffic remains as bad as ever, even worse. This argument is made on the assumption that the Delhi Metro was set up with the objective of lowering traffic congestion in the city. Now that the final outcome shows no signs of traffic improvement, they argue, the Metro project has failed.

Supporters naturally point that without the Metro Delhi would been uninhabitable. They argue that the Metro has taken 1.7 million people out of the roads, and thereby ensuring that those many people stay out of city roads. They argue that the success of the Metro is a function of how many people it is able to attract and how fast its network expands. The persistent congestion is only a reflection of the fact that the Delhi traffic has been growing at a pace faster than even the growth in the Delhi Metro traffic.

Such criticisms are commonplace with infrastructure investments. They most often fail to produce tangible and immediate impact, and leaves all stakeholders unsatisfied. When the power deficit is a few gigawatts, the commissioning of a few hundred megawatts of power generation capacity has limited impact on the load-shedding situation. Similar situation arises with even major new water and sewerage treatment capacity expansion, since the requirements are massive. The problem is most acute with transportation, since traffic always appears to worsen. In the absence of any salient impact, municipal councils have no incentive to sanction scarce resources in such sectors.

Finally, the left-wing critics of economic liberalization in India point to the persisting high poverty rates and social deprivation and blame it on the neo-liberal policies of the past two decades. They argue that these policies have exacerbated social tensions, widened economic inequality, dismantled social and economic protections and therefore weakened the nation economically.

This too is a classic counterfactual problem. There are two issues here. One, serious commentators question the nature and extent of liberalization undertaken by successive governments, claiming that they have been too little and limited in scope and piecemeal and stop-start. In the absence of, leave alone the full breadth and scope, atleast even some reasonably acceptable level of liberalization, they argue, how can we blame liberalization for the current state of affairs?

Second, they argue that in the absence of this limited economic liberalization, the economy would have been in doldrums. They point to the undoubted macroeconomic gains of recent years as proof of this. How do we know what would have the state of affairs in the absence of the liberalization policies? See Ananth's excellent take on the critics of economic liberalization, including on other dimensions.

In all three cases - stimulus measures in the US, Metro railways in New Delhi, and economic liberalization in India - there is a classic cognitive bias at work, availability bias. People observe salient outcomes - the poor state of the economy, despite the stimulus spending; poor state of Delhi traffic, despite the Metro; and the persistent high poverty levels, despite economic liberalization - and conclude that these interventions failed to achieve the outcome. However, the reality clearly (albeit less so clearly in case of stimulus) points to all having had considerable effect in mitigating the respective problems, though the exact magnitude of their impacts is difficult to quantify.

Then there is another issue here. In all three cases, the opponents frame the debate by equating the particular intervention with the text-book case of the underlying concept. Accordingly, for example, they define the stimulus as was implemented in the US was the classic Keynesian stimulus, and therefore its apparent failure to get the economy out of the recession is conclusive evidence of the failing of the underlying Keynesian concept itself.

Similarly, critics' definition of the success of metro rail as measured by the resultant reduction in congestion rate, means that an actual increase in congestion is taken as proof of its failure. For neo-liberal critics, Manmohanomics is the embodiment of economic liberalization and since it did not "eliminate poverty", as promised, it has failed!

The contraction with "expansionary fiscal consolidation"!

The big macroeconomic debate of our times is over whether economies facing the Great Recession should indulge in more fiscal and monetary expansion or should embrace fiscal austerity and monetary contraction.

Advocates of more stimulus point to dismal economic conditions - aggregate demand slump, lack of business confidence, idle capacity, depressed business investments, high unemployment rates etc - and argue that the economy would remain in a deep recession in the absence of expansionary policies. The zero-bound in interest rates, they say, only exacerbates the problems.

The Austerians point to the huge build up of public debts across most developed economies and demand immediate steps to bring them down to sustainable levels. They also see dangers of an inflationary spiral and even asset bubbles unleashed by the extended expansionary monetary policy. They also fret at bond-vigilantes driving up interest rates.

In recent months, they have pointed to the work of Alberto Alesina and Silvia Ardagna (pdf here, earlier version here) who examined episodes of all large fiscal policy stances, both stimuli and adjustments, in OECD countries from 1970-2007. They found,

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

This has repeatedly been invoked to justify "expansionary fiscal contraction" or "expansionary austerity", where fiscal consolidation will result in increased growth. It is argued that fiscal consolidation by way of spending cuts or tax increases today will, by reducing the expectations of the need for a larger and disruptive fiscal adjustment later, raise household and business expectations about their future incomes and thereby stuimulate private consumption and business investments.

They also argue that if current fiscal policy can influence agents' expectations about interest rates by signalling to them about the government's resolve, by way of fiscal stabilization, to rein in public debt, "they can ask for a lower premium on government bonds". Further, aggregate demand components sensitive to real interest rates too get a boost if such credible expectations about fiscal stabilization and lower future interest rates are conveyed. They forecast a possible consumption/investment boom if such expectations can be credibly conveyed. This study has also been used to justify the preference of tax cuts over government spending if stimulus is deployed.

A recent paper by IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori have examined the dataset used by Alesina and Ardagna and find that their findings may have been compromised by the bias within the examples used. The IMF economists drew a distinction between fiscal consolidations motivated by a desire to reduce budget deficit and those responding to prospective economic conditions. They focussed on the impact of short-term fiscal consolidation arising out of only the former and found

"Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects...

Based on the fiscal actions thus identified, our baseline specification implies that a 1 percent of GDP fiscal consolidation reduces real private consumption by 0.75 percent within two years, while real GDP declines by 0.62 percent... Our main finding that fiscal consolidation is contractionary holds up in cases where one would most expect fiscal consolidation to raise private domestic demand. In particular, even large spending-based fiscal retrenchments are contractionary, as are fiscal consolidations occurring in economies with a high perceived sovereign default risk."

As Paul Krugman writes, the Alesina and Ardagna findings are muddled by reverse causation - they mistake the rise in revenues and/or fall in expenditures that generally follows fiscal consolidation (since safety-net spending falls or government prunes down expenditures) to claim that economic expansion follows all spending cuts and/or tax increases.

Paradox of household and corporate savings

Paradox of savings is a fallacy of composition where the perfectly virtuous habit of increasing savings when embraced by everyone generates negative outcomes for the economy as a whole. This is amplified when the economy is facing a recession and aggregate demand is falling. In such circumstances, it is in the interest of the economy if people spend more to shore up the declining aggregate demand.

During the Great Recession, debt-laden households in developed economies, in particular the US, cut back sharply on expenditures and boosted their savings to repay debts.



In response, businesses too have been postponing investments. This coupled with the general trend of businesses to indulge in cost-cutting, mainly through lay-offs, during recessions (so as to, in the main, keep their bottom-lines in tact) means that businesses are sitting on hoards of cash surpluses. At 7% of all their assets, non-financial corporations’ cash and other liquid assets reached $1.9 trillion at the end of 2010, the highest level in the US since 1963.



In the final quarter of 2010, capital expenditures amounted to $975 billion, or 6.6% of gross domestic product — up from a low of 5.4% in 2009 but still well below the 10-year average of about 8%. The non-residential private fixed investments dropped precipitously during the recession.



All this highlights the pro-cyclical nature of their basic economic activities for the two critical stakeholders. When faced with uncertainty, consumers save and businesses postpone investments. In contrast, when the economy is on the up, consumers spend as though there is no tomorrow, while businesses borrow recklessly and over-invest.

Recessions are marked by declines in aggregate demand. Households and businesses shutting-off their spending taps compounds the problem. It is possible, as the East Asian economies and Germany have done on occasions, to export your way out of a downturn. Further, if the recession is not very deep, it is possible to indulge in monetary accommodation and encourage businesses to bring forward investments.

But these were not available options for the US economy at the peak of the Great Recession. Under such circumstances, there is no choice left but for governments to step in and provide a temporary boost to aggregate demand.